Value

Wherever a business uses specialist knowledge to serve its customers, its activities will have intellectual property (IP) at their core. This IP might lie in “formal” rights like patents, designs or trademarks; increasingly, in a service-driven economy, it is likely to involve proprietary processes, trade secrets and copyright material.

But IP poses companies with a common problem, wherever it may lie. While a business’s bundle of IP assets often underpins all its income streams, its worth is seldom expressed on a balance sheet. Since the underlying IP is hardly ever identified or valued, it cannot be exploited in the same way as tangible assets like property, plant and machinery – assets whose importance is reducing in an increasingly knowledge-based age.

Understating a business’s value in this way inevitably curtails its ability to borrow and to fund growth, a problem that is widely recognised in industry and Government circles. For example, at its February 2007 seminar on SMEs and their intangible assets, the ACCA summarised the position as follows: “Impetus must be given to developing an accepted valuation methodology and to stimulating intangible asset markets… It is imperative that a methodology is developed that values intangible assets so as to promote innovation within firms and the economy as a whole1” In February 2008, the DCMS paper Creative Britain concluded that: “Since most of the value of the creative sector derives from intangible assets, creative businesses must be able to value them accurately and have confidence that they will be vigorously defended under the law2.”

The way forward

There is no legal impediment to deriving greater shareholder value from IP. As its name suggests, IP is essentially a type of property, which means it can be licensed, bought and sold (or, technically, assigned) in much the same way as any tangible asset. However, to enable this potential value to be realised, two key preconditions need to be met.

Firstly, the IP’s scope and nature need to be clearly understood. This requires there to be an accepted means of describing and “commodifying” it – in other words, to transform the IP into a business asset with a separate identity, capable of being transferred to other parties. Secondly, the IP needs to have a financial value attributed to it.

Inngot’s system has been designed to overcome these two barriers. It provides new processes to explain what a company’s IP is, where its value lies, and how much it might be worth. In doing so Inngot also enables companies to make their IP known to a wide range of prospective customers, partners and investors.

With the help of Inngot’s registration and valuation regime, IP can be sold to a finance house, which then leases or licences the exclusive usage rights back to the originating business, in return for a monthly payment stream.

Inngot registration

Inngot’s systems exploit the potential of existing copyright law to create a secure environment where businesses can register and publish their IP. A unique new classification system is used to describe both the business and its IP, making it easy for potential customers, collaborators, acquirers and financiers to search for it. This is the opposite of existing copyright registration schemes, which effectively “lock away” published material.

As well as registering the IP, Inngot records the existence of any finance associated with it, creating a “notice mechanism” needed for a market in IP to prosper.

Inngot valuation

While IP valuation is conducted regularly, it is usually a “one-off” exercise in the context of a business sale or licensing agreement. Comparatives are rarely available and seldom published.

Inngot’s valuation mechanism has been created with a standardised transaction form in mind – an “arm’s length” sale to a finance house. In this context, the importance of the valuation is that the amount involved must be realistic; the asset must be worth at least the amount being lent (having factored in an appropriate contingency); and the lessee must have the ability to repay on the agreed terms.

Benefits

For companies, using IP as security provides a means to maximise the value of existing core assets without having to sell shares. All of the exclusive rights of usage remain with the originator, who can continue to develop its IP just as it would previously have done, but with the benefit of significantly more capital.

Asset finance always involves a fixed stream of payments over a given period of time, likely to compare favourably with variable bank charges. At the end of the term, a lease can revert to a “peppercorn” rental, while a licence can provide for full ownership to be returned at the end of the term. In the meantime, the fact that the legal ownership of the IP rests with a major financial institution significantly reduces the risks of deliberate infringement by a competitor.

Entering into a lease agreement does not “fix” the value of the IP, any more than the size of a mortgage determines the value of a property. If the business does well, the value of the IP will increase, opening up opportunities to realise further funding streams. This also suits the lender, as it prevents them from becoming technically “over-collateralised”.

The way forward

There are a growing number of commercial finance precedents where IP has been used to provide security for lending, and the mechanisms involved are familiar and well understood. As the marketplace develops, many of the techniques already developed in a competitive leasing market will start to be introduced, such as extended primary periods, payment holidays, peppercorns for secondary periods, and even (potentially) “balloons”. There are already signs that finance houses and brokers will develop specialisms in one or more sectors or IP types, as they have done for many years with tangible assets.

Inngot registration and valuation address the structural issues which have constrained the use of IP as security for finance to date – chiefly the lack of clear description, valuation and notice mechanisms. With these points addressed, IP-based financing becomes a very attractive option both for innovative companies and for finance companies.

Martin Brassell, CEO of Inngot, considers how founders can realise value from their hard work in a pre-start context

There are many areas in which expectations differ between investors and entrepreneurs seeking investment. One of the areas that often proves hardest to resolve is the question of valuation, especially if a business is yet to generate first revenues.

‘Sweat equity’ is the delightful term coined to describe the value to be placed on the efforts expended to bring an opportunity to the point of realisation. At the point when a business is first presented to independent investors, rather than a more receptive first audience of ‘friends and family’, entrepreneurs will often strive to place a financial value on their labours. From their viewpoint, this is a perfectly reasonable thing to do: after all, no-one doubts that bringing an innovative idea to market involves a lot of perspiration as well as inspiration.

Any investor worth having knows that the road to success is generally a steep one, and likely to require a good deal more sweat to be expended. He or she also understands that it is counter-productive to leave a founder so short of equity that they lack the commitment and energy to make the climb. However, the risk climate dictates that this is a buyer’s market at present, in which any valuation is bound to be subjected to close scrutiny, and needs to be as objective and well-evidenced as possible.

How does sweat get expressed? Generally as a factor or multiple of the salary that the entrepreneur(s) would be earning if they were in some notionally equivalent employment (or still in a previous job). The more senior time and energy put into an opportunity, the more it should be worth, and this method quantifies it – right?

Sorry – wrong, on a number of counts. To begin with, this approach assumes that hard cash and theoretical cash are equivalent in value. In reality, there is always an exchange rate in action. Sometimes this works in the founders’ interests, if they manage to get an opportunity to a point where it clearly has vastly more value than the time they have expended on it would indicate. But on other occasions, the investor is being expected to put in new cash to realise an opportunity that the theoretical cash has failed to deliver on its own. They will understandably take the view that their ‘real’ money is more risky and should attract a premium.

Even if a pound-for-pound calculation were appropriate, an investor has no way of auditing the amount of time that has actually been invested, or knowing whether the salary sacrifice implied is real or not. Certainly, people do sometimes jump out of highly paid jobs to create new ventures: but on some level, the saying that “necessity is the mother of invention” is generally applicable to entrepreneurial motivation as well as to the innovations themselves. And there is a more fundamental problem, which is the underlying premise that cost is equivalent to value.

Plainly, it’s not. The fact that it costs one company twice as much as another to produce a given widget does not translate into 2x value that the market can see. To take a less obvious example, many endeavours involve going down a number of what prove to be blind alleys. This creates ‘negative know-how’ – understanding what doesn’t work. It has some value, but clearly not as much as actually discovering the ‘secret sauce’.

To present a more compelling case requires a focus on what a pre-startup has actually been able to deliver to date. This involves consideration of assets, and since few start-ups are well enough funded to invest much in tangible ones, it inevitably comes down to the value that an investor can see in the opportunity and the company’s capacity to realise it based on a) the quality of the team (if there is one) and b) the quality of the approach embodied in its intangible assets.

An investor needs to see how the sweat invested by founders has translated into assets that create income, ‘freedom to operate’ and/or ‘barriers to entry’. Not all these assets are equal, and the type most highly prized will generally firm orders, often in short supply. However, any such orders are likely to have been secured based on capabilities that are underpinned by intellectual property and similar rights.

The more comprehensive an inventory of assets a business can produce, the better its prospects of attracting favourable attention, and the more likely it is that an investor will see that there is something of value at the heart of it. The present day value of those assets can then be extrapolated from the scale of the opportunity they enable a company to realise, and the length of time it will take for an investor’s new money to enable that opportunity to start to be realised. This comes down to having a credible and well drafted business plan, in which the risks and their mitigants are given proper consideration.

So the secret of expressing the value of sweat is simple: don’t focus on how much time you’ve spent – instead, show what you have been able to do with it.

Intellectual Property has too long been seen as a guard against imitators and should be better used forging partnerships and raising valuations, Sean Hargrave Discovers.

There are two major problems with the way the business world considers intellectual property (IP). Many companies see a patent, trademark or registered design mainly as a defensive measure and so will not look beyond these protective rights and consider what other IP the business might own.

Ultimately, everyone knows there is only one true arbiter of how much a given set of assets is really worth: how much someone else is prepared to pay for them. This maxim is even more applicable to intangible assets, which don’t (yet) have the same ready market as the tangible commodities companies own.

However, that doesn’t mean it isn’t possible, and necessary, to understand the quantum of value now resting in businesses’ Intellectual Property (IP) and other intangibles – even if these assets (or companies) in question aren’t currently for sale.

To get a sense of the contribution they make, we can look at how much companies spend on intangibles; how these assets appear to influence share values; and what happens when firms sell stakes based on an intangibles-backed offering.

Helpfully, the 2011 UK IP review by Professor Ian Hargreaves provides some (fairly) recent data on investment in intangibles. The report quotes Government statistics from 2008, showing that UK businesses now spend about one-third more on intangible assets than they do on tangible ones – £137bn vs. £104bn. A key contributor within this asset class is IP, estimated to account for around £65bn of this investment.

What about share prices? One of the organisations looking regularly at intangible values is Ocean Tomo in the USA. Its analysis suggests that the “80/20” rule now provides a good shorthand when thinking about the level of value in intangibles (read more here).

Back in 1975, the implied intangible asset value of the S&P500 (derived by looking at book value as a proportion of market value) was 17%: in 2010 it came in at 80% when measured on the same basis. The company attributes this “total economic inversion” to the growth of the knowledge economy, and points out that these implied values are holding up, even during a period when total R&D spend is falling (though it is still increasing slightly if viewed as a % of revenues).

Similar exercises have been done in Europe. The introductory section of the 2006 Gowers Review draws the same conclusion from an assessment of top companies quoted on the London Stock Exchange. The European Commission said in 2010 that “intangible value has accounted for approximately three-quarters of corporate value as far back as 1995.”

None of their findings should surprise us. Rewind to the 1970s, and Western economies were still largely dependent on generating value from manufacturing capacity – multiplying the power of human effort. Now it’s much more about multiplying brainpower, not brawn.

It is also clear that the characteristics that make companies attractive purchases have changed. With so much production capacity offshore or subcontracted, it’s the brands, customer relationships, service formats and software code that buyers want. Recent flotations of technology and web-based companies have generated plenty of initial interest despite very challenging market conditions; and while the initial gloss has faded from some of these offerings, the fact that they got away at all is undoubtedly due to their shiny intangibles, not their shiny servers.

It seems the pendulum has swung decisively towards valuing assets that are unique, rather than types of property that are common across many businesses. Determining an appropriate value for them poses new challenges for investors, lenders, acquirers and licensees.